Effective reporting of expected credit loss estimates under IFRS 9

SUITS THE C-SUITE By Geraldine Rose V. Ogerio

Business World (12/18/2017 – p.S1/4)

INTERNATIONAL Financial Reporting Standards (IFRS) 9, the replacement standard for International Accounting Standards (IAS) 39, Financial Instruments: Recognition and Measurement, is slated for mandatory adoption by entities starting Jan. 1, 2018. A key change in IFRS 9 is the introduction of a new impairment model — the Expected Credit Loss (ECL) model. The ECL model, which replaces the incurred credit loss model under IAS 39, incorporates forward-looking information in measuring impairment loss on financial instruments, with the aim of providing timely and more useful information about an entity’s expected credit losses to the users of financial statement.

In June 2016, the Global Public Policy Committee (GPPC), which comprises representatives from the six largest accounting networks, issued a paper which describes the key components of the implementation of the ECL model and provides guidance to audit committees in evaluating a bank’s progress during the implementation and transition phase.

In July 2017, the GPPC issued a second paper focused on the major components of the ECL estimation process and implications for banks and auditors to consider, and the audit committee’s role in evaluating the effectiveness of the auditor’s response to the risks of material misstatement posed by ECL estimates.

The estimation of ECL under IFRS 9 will be a significant change in a bank’s financial reporting. Given the importance of banks in the global capital markets, it is critical for bank management teams, audit committees and auditors to develop reliable and reasonable estimates of ECL and to ensure the completeness, reliability and accuracy of financial statement disclosures. It also highlights the need for auditors to perform high-quality audits on ECL estimates so that the users of financial statements can rely on these estimates and disclosures.

In order for users to better understand and evaluate the judgments used in ECL estimations, banks will need to base their disclosures on the following elements: accounting policies, operational procedures and systems of internal control, information systems and data, and estimation models.

ACCOUNTING POLICIES

The bank should ensure that its accounting policies completely capture the applicable requirements of IFRS 9 to help users understand the key decisions, judgements and interpretations applied by the bank. Moreover, the bank should consistently apply its accounting policies and periodically reassess the appropriateness of its accounting policies for any changes that may be relevant in the estimation of ECL.

OPERATIONAL PROCEDURES AND SYSTEMS OF INTERNAL CONTROL

The bank should have effective internal controls over the critical sources of information, processes and models upon which the ECL estimates are based. They should address the following:

· The appropriateness of its accounting policies and conformity with the requirements of IFRS 9;

· The completeness, accuracy, relevance and reliability of historical and forward-looking information obtained from internal and external sources;

· The development, maintenance and validation of estimation models used to determine the ECL amount, including the appropriateness of any adjustments or overlays;

· The controls in place to review the ECL estimates used, including controls designed to identify and mitigate potential management bias; and,

· The completeness, reliability and accuracy of financial statement disclosures on ECL estimates.

INFORMATION SYSTEMS AND DATA

The bank should have a robust governance process over its information systems development and implementation, including post implementation changes. The information systems should have automated controls (or manual controls if no automated controls are embedded into the information systems) to ensure the completeness and accuracy of information and the reliability of the information systems’ processing logic.

ESTIMATION MODELS

The bank should have a comprehensive framework over the model development and model validation, including policies and procedures outlining roles and responsibilities, and on model adjustments or overlays, to ensure that the models generate accurate, consistent and predictive estimates. The bank’s model validation process may include the evaluation of the model’s mathematical, theoretical or conceptual soundness, including the appropriateness of model parameters and completeness and accuracy of the model’s data, and the continued appropriateness of the models by performing back testing, stress testing and benchmarking. Model inputs must also be relevant, reliable and appropriate in the context of IFRS 9.

Accordingly, these elements will be the auditors’ key areas of focus when auditing a bank’s estimation of ECL:

· Assess the risks of material misstatement associated with the bank’s ECL estimates by gaining an understanding of the bank’s ECL estimation process, including the internal controls and information systems used in the ECL estimation process and testing the design and operating effectiveness of the key controls identified;

· Engage IT experts to evaluate the operating effectiveness of Information Technology General Controls (ITGCs) over the applications used in the bank’s ECL estimation process, which include testing the ITGCs over logical access and program change management;

· Identify the significant judgments and assumptions used by the bank that give rise to the risks of material misstatement on ECL estimates (e.g., assessment of significant increase in credit risk in a particular portfolio, selection of estimation models, use of overlays, selection and relative weighting of forward-looking economic scenarios);

· Design appropriate audit procedures to address the identified risks of material misstatement posed by the degree of complexity, extent of management judgment and estimation uncertainty in determining the ECL amount;

· Apply professional skepticism throughout the audit by developing independent estimates, performing sensitivity analyses, back testing and benchmarking, and examining subsequent events to evaluate the reasonableness of ECL estimates, assessing and reviewing the bank’s controls in mitigating potential management bias (e.g., management override of internal controls), critically evaluating all available audit evidence, and assessing the appropriateness and accuracy of the bank’s responses to questions; and,

· Assess the completeness, reliability and accuracy of financial statement disclosures, including the disclosures on the accounting policies applied by the bank, key assumptions used in ECL estimates and the credit risk in the bank’s portfolios.

As banks’ management teams prepare for the transition to and adoption of IFRS 9, audit committees will play a significant role in ensuring that banks produce high-quality estimates of ECL, financial statement disclosures and evaluating the effectiveness of the auditor’s response to the risks of material misstatement posed by ECL estimates. Audit committees will need to assess and monitor the effectiveness of auditors by considering whether auditors have the appropriate skills, knowledge and resources to address the risks involved in the bank’s estimation of ECL, assessing the appropriateness of the planned audit approach, as well as any deviations from the planned audit approach during the course of the audit, and evaluating the auditors’ findings based on the auditors’ understanding of the bank’s processes, systems and controls.

Looking ahead, the GPPC anticipates the evolution of general banking practices regarding the estimation of ECL because of new challenges and insights that may arise. In this context, banks, regulators and auditors will need to continuously monitor upcoming developments and assess any effects and changes on their respective responsibilities.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.

Suits the C-Suite resumes on 8 January 2018. Warmest greetings of the season and a happy New Year to all our readers!

Geraldine Rose V. Ogerio is a Senior Director of SGV & Co.